I have more than 35 years’ experience as an attorney and financial planner, and I’ve worked with hundreds of business owners to solve problems, exit their businesses or retain their top talent. I work all over the country with financial advisors and business owners themselves to help them better prepare for their financial future. My blog is focused on financial intelligence for business owners. I talk about current events, experiences I've had with business owners, and a lot about taxes.
Steve is a National Advanced Solutions Director with the Principal Financial Group®, Des Moines, IA 50392 and an Adjunct Professor at Drake University. While this communication may be used to promote or market a transaction or an idea that is discussed in the publication, it is intended to provide general information about the subject matter covered and is provided with the understanding that the author is not rendering legal, accounting, or tax advice. It is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
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Death Of The S Corp As A Tax Election?

A reader recently asked me if I would do an article on the death of the S Corporation (S Corp). At first, I wondered what he was referring to, but upon further consideration I realized he had a point. The S Corp as a business tax election is far from dead, however it is being threatened. The threats come from three sources: the government, creditors and benefit designers.

The Government

S Corps continue to be the most prevalent type of corporation. According to the IRS’s most recent data, about 70% percent of all corporations filed as an S Corp. Some are regular corporations electing S Corp status and some are LLCs, checking the box for corporate taxation and then electing S Corp status. Over the years, the government has both liberalized the rules for S Corps and cleaned up various abuses. They’ve limited how much passive income can be received; they’ve allowed but then tightened the rules for ownership by an ESOP; and, they’ve simplified some rules while complicating others. One topic, however, is a persistent concern for the government in terms of lost revenue from S Corps – employment tax. The concern is that S Corp owners can lowball their own wages, and thereby avoid paying FICA and Medicare taxes on their incomes. Some politicians have gone so far as to call S Corp status a “tax shelter.”

Despite all the clamor going on in Congress, there have been indications that the Ways and Means Committee is looking at changing how small, flow-through companies are taxed. One plan is to subject S Corp owners to employment tax on all of their profits. The theory is that this is more equitable, since both guaranteed payments and distribution of profits from an LLC are subject to employment tax. If Congress ever does adopt tax reform, this plan could become reality and S Corp status would lose much of its appeal. Why would an LLC elect S Corp status if the owners don’t get a break on their personal taxes? Would a new business simply start as an LLC?

Creditors

I’m astonished at how much competition there is among revenue-hungry states for the assets of high net worth individuals and their companies. Some states have courted these assets by making their creditor/debtor laws favorable to the debtor. The LLC seems to be the favored business entity for these laws. In many states, the creditor who successfully obtains a judgment against an LLC ends up with nothing more than a charging order. And more and more, these charging orders leave the creditor empty-handed because the debtor can delay or even eliminate collection.

What I’m finding is that businesses concerned about company liability issues are often being advised to form as an LLC, not as a regular corporation (otherwise known as C Corp). It’s suggested that this business form offers superior asset protection. In many cases, this also means owners gravitate towards “check the box” status as a partnership or sole proprietor for federal income tax purposes. This movement towards LLC legal status may portend a decrease in creation of regular corporations electing as an S Corp.

Benefit Designers

Many small business owners are in for a shock this year — thanks to the American Taxpayer Relief Act and Patient Protection & Affordable Care Act, income taxes on the affluent went up in 2013. Because of this increase, we are returning to the days when there is, once again, a difference between the top marginal tax brackets of corporations and individuals. The top tax bracket for a C Corporation is 35%; the top tax bracket for an individual taxpayer is 39.6% plus the 3.8% Medicare Surtax. I’m hearing rumblings in the tax planning community that perhaps C Corp status should be more actively considered for small businesses. While the tax arbitrage between corporate and individual tax brackets alone might not justify the double taxation of C Corp status, the superior benefits planning opportunities may.

With a C Corp, employees/owners can participate in nonqualified deferred compensation plans without having the deferred income come back to them as currently-taxed company profits. Although the owner is ultimately responsible for the corporate tax, in some cases this can still be an effective tax planning tool. They can also participate in group term life and disability income plans with the same favorable tax benefits that non-owner employees enjoy. The personal income taxes owners saved or deferred may be enough to offset the fact that they will be subject to tax at both the corporate and individual level.

I’m in no way promoting the idea that S Corp status should be avoided. There’s a reason more than two thirds of corporations elect this tax regime. Plus, it is a particularly flexible status for owners contemplating the eventual sale of their stake in the business. I do, however, think S Corp should not be considered the automatic status for a small, closely-held business. There are other approaches; and, planning in advance may save taxes in the future.

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Thank you for the article. I am trying to make this determination. I am paid through contract work and have found that they had me setup as a 1099 vendor using my personal name. I thought I had done filing correctly by giving just my company name and EIN number. So now I am going to correct that. This brings me to your article which has shed some light on the true nature of things. The check boxes (on the 1099) were a bit confusing as I thought an LLC was sufficient. But now will need to fill out some new paper work to get things right. And choose the right box. Decision pending. Thanks for the clarification.

I agree with your comments that the federal government would probably like to apply self employment tax to ALL earnings from closely held S Corporations, but I think you go astray trying to equate the legal form of entity, LLC or Corporation to the tax designation of S Corp, C Corp or partnership/disregarded entity.

If an S Corp is an LLC that elected S classification, then there is no difference in the legal form of the entity than if the LLC had elected to be a partnership or disregarded entity. They are the same legal entity subject to the laws and legal statutes of the state where the LLC was formed.

It is probably a fine point I make, but I get so many client inquiries about should their business be an S Corp or an LLC because of misinformation they get reading about these things on the internet.